QUESTIONS NUMBER ONE. Required:

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1 NUMBER ONE (a) Required: QUESTIONS As an expert in the financial management of public projects, you have been requested to present a seminar paper on Project Management in the Public Sector; challenges and dilemmas. Explain the main issues you would address in your paper under the following headings: (i) Phases of a public project. (4 marks) (ii) Planning and control techniques for a public project. (4 marks) (iii) Causes of failure of public projects. (2 marks) (b) Donii Limited has a cost of equity of 10%. Currently it has 250,000 ordinary shares which are quoted at the Stock Exchange of Sh. 120 per share. The company s earnings per share is Sh. 10 and it intends to maintain a dividend payout ratio of 50% at the end of the current financial year. The expected net income for the current year is Sh. 3 million and the available investment proposals are estimated to cost Sh. 6 million. Required: (i) (ii) Using the Modigliani and Miller (MM) model, show that the payment of dividends does not affect the value of the firm. (8 marks) What are the assumptions inherent in the MM model? (2 marks) (Total: 20 marks) NUMBER TWO (a) Total Risk Management (TRM) will become a common term in finance just like Total Quality Management (TQM) has in production and marketing. (Professor Andrew W. Lo. 1999). Required: (i) Define risk management as used in finance. (2 marks)

2 (ii) Discuss reasons why risk management might increase shareholders wealth. (8 marks) (b) Masaku Limited has set aside Sh. 40 million for investments as on 1 January Five proposals are presented to the company s board of directors by the finance manager as shown below: Project Initial cost Sh. 000 A B C D E 10,000 30,000 15,000 12,000 18,000 Annual revenue Sh ,000 30,000 18,000 17,000 8,000 Annual costs Sh ,000 10,000 6,000 8,000 2,000 fixed Life project (years) of Additional information: 1. Projects D and E are mutually exclusive. 2. Each project is divisible and can only be undertaken once. 3. Variable costs are 40% of annual revenue. 4. All cash flows will occur at the end of the year commencing 31 December Cost of capital is 10% (ignore tax). Required: i. Determine the optimal allocation of the Sh. 40 million amongst the five projects. (8 marks) ii. What is the net present value resulting from this allocation? (2 marks) (Total: 20 marks) NUMBER THREE (a) The board of directors of Matuu Limited is divided on whether to adopt a high or low dividend payout policy. One of the directors has quoted the dividend discount model as proof that the higher the dividends, the higher the share price.

3 Required: (i) (ii) Highlight two arguments for and against a high dividend payout policy. (4 marks) Using a constant growth dividend discount model, evaluate the director s statement. (6 marks) (b) Kingo Plastics Limited is an all equity financed company. It had three strategic business divisions as on 1 January 2004: 1. The Polythene division It has a capital of Sh. 8 million and is expected to produce returns of 11% on capital for the next five years. Thereafter, it will produce returns equal to the required rate of return of 14% for its risk level. 2. The Paper division It has a capital of Sh. 12 million and a planning horizon of 10 years. During this planning horizon, it will produce a return of 12% on capital compared with a risk adjusted required rate of return of 15%. 3. The Container division It has a capital of Sh. 12 million and a planning horizon of 7 years. The required rate of return on capital is 16% compared with the anticipated actual rate of 17% over the first seven years. Required: Calculate the present value of the company as on 1 January (10 marks) (Total: 20 marks) NUMBER FOUR (a) Globalisation has resulted in several organizations engaging in corporate alliances and the establishment of several trading blocks. The advent of e- commerce has enabled companies to greatly expand their markets. Required: Identify and elaborate on five factors that complicate financial management in multi-national firms. (10 marks)

4 (b) Kentaj Electronics Limited has taken delivery of 50,000 electronic devices from an American company. The seller is in a strong bargaining position and has priced the devices in American dollars at $12.00 each. Required: Kentaj Electronics Limited has been granted three months credit. Assume that interest rates in America are 3% per quarter (three months). Kentaj electronics Limited has all its money tied up in its operations but it could borrow in dollars at 3% per quarter if necessary. Foreign exchange rates US$ = Sh. 1 Spot Three month forward A three month dollar call option for US$ 600,000 is available at a premium of US$15,000. (i) Using suitable computations, illustrate two hedging strategies available to Kentaj Electronics Limited. (8 marks) (ii) Distinguish between a currency option and a currency swap. (2 marks) (Total: 20 marks) NUMBER FIVE (a) (b) With reference to the measurement of portfolio risk, distinguish between Portfolio theory and the Capital Asset Pricing Model (CAPM). (4 marks) The following details relating to Badu Limited show how the level of gearing affects the company s cost of debt. Gearing level (%): Pre-tax cost of debt (%): Required: Determine the company s optimal capital structure. (6 marks)

5 (c) The investment portfolio of Gathara Limited consists of shares in five companies operating in different industries. Company A Ltd. B Ltd. C Ltd. D Ltd. E Ltd. Amount Invested (Sh. million) Stock beta Coefficient The risk free rate (R f ) is 8%. The market returns have the following probability distribution for the next period. Market return % Probability Required: (i) Compute the expected return from the market (R m ). (2 marks) (ii) Calculate the beta coefficient for the portfolio (β p ). (4 marks) (iii) Determine the equation for the security market line. (4 marks) (Total: 20 marks)

6 (i) NUMBER ONE (a). PHASES/STAGES OF PROJECT MANAGEMENT 1. Planning phase This stage is concerned with articulation of the broad investment strategy and the generation/preliminary screening of project proposals. The investment strategy defines the broad areas of the types of investment that the firms plans to undertake. This provide a framework that shapes, guides and circumstances the identification of the individual projects. 2. Project analysis If the preliminary screening suggests that the project is prima facie worthwhile, a detailed analysis of the marketing technical, financial, economic and ecological aspects is undertaken, the forecast of this stage is on gathering and summarizing relevant information of various project proposals that are being considered. Based on information developed in project analysis, the stream of costs and benefits associated with the project can be defined. 3 Project selection This follows and often overlaps analysis It addresses the question is project worthwhile. A wide range of proposal criteria have been suggested to judge the worthwhileness of the project. Criteria Accept Reject Payback Period ARR NPV IRR PBP < the targeted period ARR > Target rate NPV > 0 Benefit Cost Ratio (BCR) IRR cost of IRR capital Accept if (BCR) > 1 PBP > the targeted period ARR < Target rate NPV < 0 cost of capital Accept if (BCR) < 1

7 4 Project implementation The implementation phase consists of several stages especially for industrial process. 5 Project Review Once the project is commissioned the review phase is set in motion. Performance review should be done periodically to compare actual performance against the project performance. A feedback device is useful in several ways. It throws light on how realistic the assumptions on defying the project It provides a log of documented experience that is highly valuable in future decisions. It suggests collective action to be taken in light of actual performance. Helps in uncovering judgemental biases It induces a desired caution among the project personnel. (iii) PROJECT PLANNING AND CONTROL TECHNIQUES Project contract basically start with project planning since the project is the key to determination of adequate contract procedures and mechanisms. The contract techniques used throughout in the project management stage include: 1. Work breakdown 2. Project planning (Ghantt) charts 3. Network plans 4. Critical path methods 5. Program evaluation and review techniques 6. Network analysis using historical estimating behavior 7. Network simulation 8. Simulation using historical estimating behavior 9. Graphical Evaluation and Review Techniques(GERT) 10. Line of Balance (LOB) (iii) Causes of project failure Project failure means a failure of the project to meet its desirable

8 objectives within its desirable costs. Where the desired objective is to generate a profit, the failure is clearly in a large part of the financial failure. However, where the desired objective is not a financial one, the possibility of completing the project with a reasonable cost has an important financial as well as technical aspect to it. Main causes of project failure include: Unclear aim or inadequate definition of requirements i.e. poor project planning/feasibility. Inadequate project control failure to use project control. Inadequate/poor project management Project team may not be qualified for their responsibilities. Project manager Project engineer Project control engineer Project purchasing officer/agent Project accountant Project construction manager Engineering coordinator Areas superintendent Liaison officer Inadequate information flows due to poor management information system (MIS) Confusion of responsibilities due to political interference Failure of the sub-contractors Faulty equipments using poor materials Labour problems e.g. strikes, go slows, labour turnover.

9 (b) (i). According to MM, the price of a share today. (Po) is actual to the present value. (1). Expected DPS (d1) at year end (2). Expected MPS (p1) at year end * Po = d1 + P1 1 + ke d 1 = Sh. 10 x 50% = 5 P o = Sh 120 K e = 10% P 1 =?? P 1 = P o (I + K e ) d 1 = 120(1.10) 5 = Sh. 127 * Amount of capital to raise from issue of new shares = Investment needs retained earnings = 6m [3 (250,000 shares x Sh. 5)] = 4.25 m * To raise Sh. 4.25m new shares will be issued at Sh. 127 each. Number of new shares = Sh 4.25m = Sh. 127 Add existing shares Total shares * Value of the firm = shares x 127 6m + 3m 1.10 = = Sh. 30m 1.10 Alternatively *. If no dividends are paid, EPS d1 = 0 Po = Sh 120 Ke = 10% = 0.10 P1 = P1(I + Ke) d1

10 = 120 (1,10) 0 = 132 *. New funds to raise = Sh. 6m 3m = Sh.132 per share. New shares Sh 3m = Sh. 132 Add existing shares = Total Sh.132 = Value of firm = ( x 132) = 30m With and without dividends, the value of the firm is Sh. 30m hence dividends are irrelevant (ii). Assumption of MM no personal and corporate taxes perfect certainty by investors such that required rate of return is equal to cost of capital perfect capital markets without transaction cost and there is free flow of information investment decisions are fixed and independent of financing and dividend decisions. NUMBER TWO (a) (i) In the context of Financial Management, risk management involves identification of events and occurrences that could result in adverse financial consequences and negatively affect shareholders wealth and then take convective actions to prevent or minimize the negative consequences of such events. (ii) Risk management would increase shareholders wealth in the following ways. ensuring reduction in transaction costs and foreign exchange losses. Lower interest changes by managing interest rate risk through options interest rate futures interest rate swaps etc. Lower volatility of cashflow generated by projects hence higher stock prices Tax shield stable earnings ensures more tax credit compared to

11 volatile earnings Stability of cashflows, lower borrowing cost and lower profitability of Financial distress. (b) Since the projects are divisible and assuming a simple period capital rationing, then use profitability index to allocate the Sh. 40m. If variable costs are 40% of sales, contribution margin is 60% a hence in absence of taxes, cashflows will be determined as follows. Cashflows = Sales Variable costs Fixed cost = Contribution margin Fixed cost. Project Contribution Margin A 12.0 B 18.0 C 10.8 D 10.2 E 4.8 Fixed Cost Cashflow p.a Economic Life PVAF 10% NPV = = = = = 3.3 Project D and E cannot be undertaken together Project Profitability = Total P.V index Initial A B C D E cost = = = = = = Ranking Allocation of Sh 40 million Project Initial capital NPV A B

12 C 12 balance 12/15 x Total NPV Total NPV = NUMBER THREE (a). (i) (ii) Case for payment of higher dividends where dividends attract lower tax rate compared to capital gains where non-payment of dividends would attract tax penalties from authorities e.g. refer to Section 24 of Cap 470 clientele effect i.e. where low income class of supplement their low income signaling effect where management pay high dividends to send signals to the market (information signaling hypothesis) where a firm is threatened with a take-over bid and payment of high dividends will persuade shareholders not to sell their shares to the predator. Case against payment of high dividends where taxes on dividends are higher than on capital gains the firm require cash to finance investment opportunities when payment of dividends have no effects on value of the firm ( MM dividend irrelevance **mean) financial distress paying high dividends will lead to high borrowing leading to financial distress payment of dividends contravenes the bond covenants. The constant growth model states that the real intrinsic value of a share (Po) is equal to the total present value of all the expected future cashflows or dividends discounted at cost of equity (Ke) Po = do (1 + g) Ke g To maximize Po, maximize do (1 + g) i.e. expected dividend per share maximize growth rte, g, but not beyond Ke minimize Ke but not below g.

13 (b) (i) (ii) however, payment of high dividends may increase gearing and subsequently increase Ke and reduce g. Polythene division Cashflows 11% x 8m = % x 8m = 1.12 Total Paper division 12% x 12m = % x 12m = 1.80 Container division 17% x 12m = % x 12m = 1.92 Timing (years) 1-5 p.a 6 - p.a PVAF 14%, n x 0.519* 0.14 P.V * PVAF 14%, 5 = p.a 11 - p.a 1 7 p.a 8 - p.a PVAF 15%, n x x P.V m Total P.V for the three divisions NB. Each division is a going concern and beyond the planning horizon, the division is assumed to generate cashflows at a rate equal to the cost of capital. A currency option is an option to buy or sell a given amount of currency at a given exchange rate (strike price) at a given future date. - the option to sell is called a put currency option used by exporters while the option to buy is called a call currency option used by importers - currency option could either be over-the-counter option or traded options.

14 A currency swap is an arrangement between two parties to exchange debt or loan obligations denominated in different currencies. The loan obligations are nominal and the principal amounts are exchanged at an agreed interest rate. The swap is usually on agreed loan obligations and agreed term or maturity period. Challenges facing the firm involved in multinational operations Different currency denominations Cash flows in the various part of a multination corporate system will be denominated in different currencies. An analysis of exchange rate and the effect of fluctuating currency value must be included in financial analysis. Economic and legal Remifications Each country has its own unique political and economic institutions governing business. These institutional differences among countries may cause significant problems for a corporation that is coordinating and controlling worldwide operations of its subsidiaries e.g. differences in tax loss can cause a given economic transaction to have significantly dissimilar after tax consequences depending on where the transactions occurred. Political Risk This gives the potential discontinuity of a multinational operations in a host country due to the host country implementation of specific rules and regulations e.g nationalization, expropriation or confiscation. A host country exercise sovereignty over the people and property in its territory. Hence a host nation can place constraints on the transfer of corporate resources and even expropriate without compensation to the firm. 4. This risk tend to be given and cannot be changed even with negotiation. A joint venture with the government or a company in the host country can reduce this risk. Rates of Interest

15 Many rates of interest operate at any one time in different countries. Differences in the cost of borrowing or lending across borders arise from the market expectation about the future exchange rates. The finance manager need to study different interest rates and exchange rates when borrowing or lending in foreign currency. Exchange Controls Some governments impose tight controls on movement of funds out of and even into their countries. Exchange controls tend to style or reduce the trade between countries and if the company is trading in a country which impose tight exchange controls, the finance manager need to know or understand which exchange control exists and how they are applied. Political System (and the role of the government) Frequently the times under which company competes, the actions that must be taken or avoided and the terms of trades of various transactions are not freely determined in the market place especially for countries ruled by dictatorship. They are however negotiated directly between the host country and the multinational corporation. If the finance manager is trading with or in the country that is ruled by dictatorship, the rules of trading can appear to be inflexible or irrational. The finance Manager needs to adopt its style to conclude successful negotiations in such regime. Cultural and Religious Differences Different countries have unique cultural heritages that shape values and influence the role of business in the society. When defining the appropriate goals, attitude towards risks dealing with employees e.t.c., considerations must be given to the cultural differences among/ across countries. The Language Differences Communication is critical in all businesses and to penetrate another market, the company need to have knowledge of language to communicate with managers, workers and consumers. Return Considerations

16 NUMBER FOUR Domestically, competitive pressures may be such that only a normal rate of return can be earned. A firm may invest abroad so as to produce more efficiently due to existence of cheaper factor of production. Taxation Tax laws are different in different countries and therefore a firm may invest abroad to minimize tax payment to the government (b) The exchange rate is in form of indirect quote which indicates the amount of foreign currency (US $) per unit of domestic currency ( Ksh.) (i) (ii) Forward contract The firm could contract to buy $600,000 at an agreed 3 month forward exchange rate. This rate is given as $0.0154/ Ksh. 1 Ksh. = $0.0154? = $600,000 Ksh. payable = 600,000 x 1 = Ksh. 38,961, Leading The Kenyan importer may opt to pay the $600,000 now but the Ksh. is appreciative against the $ which is advantageous to the Kenyan importer. This is not a viable option but would be if the evaluated amount is paid now, the Ksh. payable would be $600,000 = 46,153, assuming the firm does not have this money, it would borrow and pay interest in Kenya for 3 months so that future value would be Ksh. 46,153,846 ( 1 + r) where r = 3 month Kenyan interest rate. (iii) Money market hedge The firm has a liability of $600,000. It needs to create an asset by depositing some money in U.S.A. This hedging would arise as

17 follows: (a Deposit some dollars in USA now which will, together with ) interest, equal $600,000 in 3 months time. The amount to deposit today = $600,000 = $582,524 = present value 1.03 (b ) The equivalent Ksh. now = $582,524 = Ksh. 44,809, This amount would be borrowed in Kenya now and assuming this could be borrowed at 3% for 3 months, the future value of Ksh. 44,809,559 would be 44,809,559 (1.03) = Ksh. 46,153,849. (iv) (c ) Meanwhile, at end of 3 months, the deposited $ will mature to $600,000 and used to pay the USA seller. Use of options The examiner did not give the strike or exercise price but assuming the forward rate of $0.0154/ Ksh. then, Ksh. payable $600,000 = Ksh.38,961, premium payable now = $ 15,000 = 1,153, if this premium was borrowed at 3% in Kenya, amount in 3 months would be: Ksh. 1,153,846 x 1.03 = 1,188,462 40,149,501

18 NUMBER FIVE (a) The difference between portfolio theory and capital asset pricing model (CAPM) is explained by the following factors Portfolio theory is concerned with total risk as measured by standard deviation. CAPM is concerned with systematic or market risk only using beta factor. Portfolio measures the risk of all assets held in a portfolio. CAPM measures the risk of individual securities/ assets that would be added into a portfolio. In evaluative portfolio performance portfolio theory measures the performance in terms of per unit of total risk i.e. ERp Rf p CAPM measures the performance in terms of returns per unit of systematic risk i.e. ERp Rf Bp Where ERp = % expected returns of a portfolio Rf = risk free interest rate Bp = portfolio Beta factor measuring systematic risk p = total risk of portfolio returns measured by standard deviation (b) From casual observation, the optimal debt level is simply 10% debt, 90% equity since it has the lowest cost of debt (Kd). The examiner did not give the corporate tax rate but even if a 30% rate is assumed, the answer won t change. The Kd at various debt levels would be as follows: % debt (yearly) % equity After tax cost of debt (Kd) 6.50 (1 0.3) = (1 0.3) = (1 0.3) = (1 0.3) = (1 0.3) = 7.00

19 (1 0.3) = (1 0.3) = The best gearing is 10% debt, 90% equity since Kd is lowest. However, this does not represent the optimal gearing (mix of debt and equity) at which point the overall cost of capital should be lowest and value of the firm maximized. (c) (i) Expected market return ERM = (10 x 0.10) + (12 x 0.2) + (13 x 0.4) + (16 x 0.2) + (17 x 0.10) = 13.5% (ii) Compa ny A B C D E Amt invested Sh. m Beta Overall or portfolio beta = 900 = Weighted Beta m (iii) the security market line (SML) is in form of regression equation Y = a + bx Where Y = required returns of a security/ portfolio a = Y intercept = risk free rate (Rf) 8% b = gradient = Beta factor x = excess returns above risk free rate = ERM Rf Y = 8% + (13.5 8) B for any portfolio j, required returns Rj = Rf + (ERM Rf) Bj = Bj OR Y = B (SMC equation) For our portfolio,

20 Rj = x 1.80 = = 17.9%

You have been provided with the following information about a project, which TOB Ltd. is planning to undertake soon.

NUMBER ONE QUESTIONS You have been provided with the following information about a project, which TOB Ltd. is planning to undertake soon. Cost of equipment Economic life Installation costs Depreciation